~ Knowing is not enough; we must apply. Willing is not enough; we must do.

What’s Wrong with Bitcoin

There are many debates on the technical shortfalls in the design of Bitcoin such as the block size, transaction throughput, etc. But the biggest problem of Bitcoin is its anti-economics mindset.

Wrong Assumption

Although Satoshi Nakamoto never mentioned financial crisis in the Bitcoin white paper, many people believe that it was the reason (or at least one of reasons) that drove the mystical genius to create the cryptocurrency. Some people also believe that cryptocurrencies will be the cure to the next financial crisis. For example, a recent article in IEEE Spectrum starts with

Bitcoin was hatched as an act of defiance. Unleashed in the wake of the Great Recession, the cryptocurrency was touted by its early champions as an antidote to the inequities and corruption of the traditional financial system. They cherished the belief that as this parallel currency took off, it would compete with and ultimately dismantle the institutions that had brought about the crisis.

To be clear, financial crisis was not caused by what currency you used and won’t be prevented by a new currency, no matter physical or virtual, crypto or not. As history showed, the euro brought a lot of benefits to eurozone states but didn’t prevent the European sovereign-debt crisis even though the member states are meant to meet strict criteria, such as a budget deficit of less than three percent of their GDP, a debt ratio of less than sixty percent of GDP, low inflation, and interest rates close to the EU average.

The problem Satoshi tried to solve is how to make payments over a communication channel without a trusted party:

What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.

Bitcoin beautifully solves this problem, theoretically. If we live in a bitcoin-only world, we may achieve this noble goal. The reality is that there are third parties involved in the overall process. For example, we need brokers of Bitcoin for fiat currency and other cryptocurrencies. You probably heard of Coinbase, Gemini, or BitPagos, right? If we still need trusted third party in the ecosystem, will Bitcoin fully achieve its goal ever?

Even worse, the security of a system is as strong as the weakest link. Although Bitcoin itself is very secure so far, the ecosystem is not. Mt. Gox was a bitcoin exchange handling over 70% of all bitcoin transactions worldwide, as the largest bitcoin intermediary in 2013. However, Mt. Gox closed its exchange service and filed for bankruptcy protection in 2014 when it discovered that approximately 850,000 bitcoins (valued at $450+MM at the time) belonging to customers and the company were missing. Tokyo security company WizSec concluded that “most or all of the missing bitcoins were stolen straight out of the Mt. Gox hot wallet over time, beginning in late 2011.”

Even if we live in a Bitcoin Utopia where there are no third party at all in all payment transactions, can we avoid financial crisis for ever? NO. Getting rid of third party in payment doesn’t mean the elimination of banks, which Bitcoin lovers hate. Banks are mostly the brokers between capital and borrowers, not just the intermediary of payments. It is easy for us to point fingers to banks when crisis happens. Sure, banks played a notorious role in the financial crisis with their risk appetite and innovations of balance sheet “optimization”. But shall we not forget the unsustainable debt level created by ourselves? A cryptocurrency or any technical innovation is not the answer if we don’t change our financial behavior.

Decreasing Coin Supply Rate

Bitcoins are created each time a user discovers a new block. The number of bitcoins generated per block is set to decrease geometrically, with a 50% reduction every 210,000 blocks, or approximately four years. The decreasing-supply algorithm of Bitcoin approximates the rate at which commodities like gold are mined (actually Satoshi has never justified or explained many of the constants in the algorithm). But which modern economy links its currency to gold today?

The currency supply rate by a central bank is supposed to match the growth of the amount of goods that are exchanged so that these goods can be traded with stable prices. The supply algorithm of Bitcoin predicates the failure that it will never become the major currency of a stable economy.

Finite Supply

Because of the decreasing supply rate, the number of Bitcoins in existence is not expected to exceed 21 million. Everyday, we create more wealth but the cap of Bitcoin is fixed. No wonder the price of Bitcoin has been skyrocketing (let’s forget the speculation, a major driver of rising price, for a second). CFTC is spot on by treating Bitcoin and other cryptocurrencies as commodities rather than currencies.

No Governance

As a peer-to-peer system, Bitcoin has been sold to us that it is good without central governance. But we do need governance on the coin supply to better serve our economy. Given the extreme complexity and volatile dynamics of economy, any prescribed supply algorithm will fail. One may criticize central banks over imperfect monetary policy. But no governance is not a better alternative.

Environmental Cost

Satoshi argues that the transaction cost of traditional electronic payments is high because of the cost of mediation with financial institutions. It is intuitive that we can reduce the cost by removing the middleman. But the truth is that we the society pay very high cost for Bitcoin. The community of miners uses vast quantities of electrical power in the process. The current estimated annual electricity consumption is 23.32 terawatt hours. The innocent truth is that Bitcoin is not environmentally friendly.

New cryptocurrency is proposed almost everyday to improve some technical aspects of Bitcoin. But no one attempts to address aforementioned issues yet.